The Incredible Shrinking Exemption for Trading Outside of the US
With the publication of proposed rules (Proposed Rules) to implement section 619 of the Dodd-Frank Act (DFA), the four federal agencies issuing the proposal (the Securities and Exchange Commission (SEC), the Federal Deposit Insurance Corporation (FDIC), the Board of Governors of the Federal Reserve System (Federal Reserve) and the Office of the Comptroller of the Currency (OCC) (collectively, Agencies)) posed a significant challenge to foreign banks with US branches, agencies or subsidiaries and US affiliates (Covered Foreign Banks). If implemented as proposed, section 619 would greatly expand the reach of US financial services regulation around the globe and could decimate the largely non-US trading activities of Covered Foreign Banks as currently conducted.
To avoid this, Covered Foreign Banks will be forced to choose between complying with the provisions of section 619 or leaving the US financial markets. From either result, the world's largest and most liquid capital markets–which currently reside in the US–will build a wall around its trading shores. Such an extreme aftermath is not required by the text or purpose of section 619, however, and Covered Foreign Banks should provide their views and comments to the Agencies.
This alert looks at the effects of the ban on proprietary trading on Covered Foreign Banks and suggests how the Agencies could amend the Proposed Rules to ameliorate these concerns while remaining true to the spirit and letter of section 619.
Section 619 of the DFA creates a new section 13 of the Bank Holding Company Act of 1956, as amended (BHCA).1 This section will ban certain forms of proprietary trading and principal investments in hedge funds and private equity funds. The Proposed Rules are an attempt by the Agencies to implement the provisions of section 619. For a full review of the Proposed Rules, please see our recent alert, "Agencies release proposal to implement Volcker Rule and request comment."2
Among the key provisions of section 619 for Covered Foreign Banks are the definition of entities covered by the prohibitions of section 619 and the definition of "solely outside the United States" as an exemption from those prohibitions. Below we review how the Proposed Rules would apply to Covered Foreign Banks and also suggest alternative methods for the Agencies to achieve what we believe to be their goals.
The purpose of section 619 is not spelled out in its text, although separate language in this section does direct the Financial Stability Oversight Council to make recommendations on its implementation so as to minimize risky activities by insured depository institutions and to limit the inappropriate transfer of federal subsidies from institutions that benefit from deposit insurance to unregulated entities.3
This purpose lines up cleanly with section 4 of the BHCA,4 which also separates "risky" non-financial activities from core banking activities supported by FDIC insurance. The Federal Reserve has applied the non-banking restrictions of section 4 of the BHCA to Covered Foreign Banks in order to preserve the competitive balance of banking in the US, as required by section 8 of the International Banking Act of 1978.5 These non-banking restrictions generally prohibit Covered Foreign Banks from engaging in the US in any activities that are not financial activities, as defined in the BHCA. In its assessment of whether activity is conducted "outside of the United States," the Federal Reserve has not previously taken the position that if any portion of the activity touches the US it will be considered a US activity. But that is exactly what the Proposed Rules state in the Preamble to the Proposed Rules (Preamble), which provides that the exemption for transactions "solely outside of the United States" acts to limit the extraterritoriality of section 619 while preserving the competitive balance among US banks and Covered Foreign Banks in the US.6 In fact, the narrow definition of the Proposed Rules actually achieves the opposite: it uses the broad reach of the US capital markets to apply the prohibitions of section 619 worldwide to Covered Foreign Banks to preserve competitive balance among all banks outside of the US.
How Will a Covered Foreign Bank Know if a Transaction is Done "Solely Outside the United States"?
The Proposed Rules place a tremendous compliance burden on Covered Foreign Banks to show that transactions will be done in compliance with the terms of the exemption. The Preamble states that the proposal focuses on the extent to which "material elements" of a transaction occur within the US. However, the terms of the Proposed Rules instead focus on the miniscule and ministerial.
Section _.06 of the Proposed Rules contains the terms of the "solely outside of the United States" exemption, and in essence these terms break down into three categories: (i) rules governing the status or conduct of the Covered Foreign Bank, (ii) rules governing the nature of the counterparty(ies), and (iii) rules governing the particulars of the specific transaction. We review each of these in turn.
Status or Conduct of a Covered Foreign Bank
Although every Covered Foreign Bank is subject to the prohibitions of section 619, the Proposed Rules make available the exemption solely to transactions conducted by those banks in compliance with Subpart B of Federal Reserve Regulation K.7 Perhaps the Agencies mean only to reference the qualifying foreign banking organization (QFBO) test of Subpart B of Regulation K, a test which by reference to a bank's assets and revenues seeks to ensure that only banks whose activities are truly primarily outside the US are eligible to take advantage of the exemptions offered by Regulation K (or a similar test meant to apply to foreign commercial or industrial companies that control certain US thrifts or industrial banks). If so, the Agencies should clarify this provision to ensure that the QFBO test alone is used as an eligibility criteria, and that the reference to Regulation K is not intended to require substantive compliance with Regulation K’s established investment rules in addition to the "solely outside of the United States" criteria.8
Similarly, the Proposed Rules provide that a Covered Foreign Bank must not be directly or indirectly controlled by a US banking entity. This requirement seems consistent with the QFBO test discussed above. However, the Preamble states that "[t]his requirement limits the scope of the exemption to banking entities that are organized under foreign law and controlled only by entities organized under foreign law" (emphasis added).9 Thus, the limitation on the availability of the exemption would potentially extend to non-US banks with significant US ownership. This extension could restrict US funds from making significant investments in non-US banks. This interpretation appears entirely unnecessary for the Agencies to achieve their purpose of limiting the exemption to "true" non-US banks (or entities), as measured by the QFBO test.
The language of section 619 also includes within the scope of the exemption entities eligible to use section 4(c)(13) of the BHCA (generally US entities that act almost entirely outside of the US); the Agencies, based on Federal Reserve past precedent, have decided not to include such entities within the Proposed Rules. The Agencies did, however, ask a public question about whether they should include those entities within the scope of the exemption.10 As discussed below, the existence of this language in section 619 appears to cast significant doubt on the prongs of the exemption that prohibit US persons or execution facilities from being involved with a transaction.
Nature of a Counterparty
The Proposed Rules require that "no party to the purchase or sale is a resident of the United States."11 "Resident" is then defined in eight subsections.12 Many of the definitions could cover entities that are truly non-US but have de minimis contact with the US. For example, subsection (i) refers to any natural person resident in the US. This definition could pick up foreign persons who happen to be traveling in the US. Subsections (iv) and (vi) look at whether there are any beneficiaries of trusts or accounts that are US residents. This definition could pick up an entity where one of 100 named parties happens to be a US resident. Perhaps most confusingly, subsection (viii) lists any entity formed under foreign law by or for a US resident primarily for trading purposes.
This definition raises many questions. What of non-residents with significant US ties? What if a non-US resident is owned or controlled by a US resident but not organized for trading purposes? What levels of shareholding are relevant? Or what of transactions done entirely with non-US residents, but which are for the benefit of a US resident? We believe that none of these entities should be considered "residents" for purposes of section 619.
What all these definitions have in common is that a Covered Foreign Bank will have to diligence its counterparties' origins, shareholdings, beneficiaries, locations, and intentions before being able to rely on the exemption. This is quite a bit of work for entities that individually engage in an overwhelming number of such transactions annually. Will the Covered Foreign Banks be able to rely on representations by their counterparties as to these facts? Or will they be required to investigate each and every entity? And what if they reasonably believe that their counterparties qualify, but are ultimately wrong? Under the Proposed Rules, as drafted, there are no innocent mistakes, only exemptions and prohibitions.
Finally, we note that where the Proposed Rules state that "no party" can be a US resident, they appear to be contradictory to the reference in section 619 to section 4(c)(13) of the BHCA, which explicitly permits US entities to be a party to a transaction, so long as the entity does no business in the US (except for certain incidental business).13 Direct investments by US entities in non-US transactions, such as through "Edge" Corporations, have been consistent with Federal Reserve practice for many years.14
Particulars of a Transaction
The Proposed Rules require that (i) no personnel of the Covered Foreign Bank directly involved in a transaction be located within the US, and (ii) the transaction be executed wholly outside the US.15 Looking at the first prong, the Preamble states that persons performing purely administrative, clerical or ministerial functions would not be considered to be directly involved for these purposes (note that the text of the Proposed Rules itself does not say this). However, this prong leads to the conclusion that a transaction that otherwise would be considered solely outside the US would be pushed outside of the exemption solely because one person located in the US may have worked on it. The potential ramifications of this interpretation could be vast and lead directly to an exodus of financial jobs from the US. Consider, for example, the many Covered Foreign Banks that have organized their Latin America trading desks within the US for convenient time zone purposes. These trades are between non-US parties, are booked outside of the US, but are structured and managed within the US. They pose little risk to the US financial system and have little impact on the competitive landscape between US banks and non-US banks. There is no reason why these trading desks must be located within the US; adoption of the Proposed Rules will almost certainly lead to the movement of this business outside the US.
We also wonder if "personnel" could include non-employee advisors of the Covered Foreign Bank, such as accountants, attorneys, and other consultants. We hope not. And, as noted, this restriction appears to contradict the language of section 619, which references section 4(c)(13) of the BHCA and permits US entities (and presumably their US personnel) to be involved in such transactions outside of the US.
The second prong requires that a transaction be executed wholly outside of the US in order to qualify for the exemption. The Preamble does not indicate how the Agencies will define "execution" but instead refers to the use of "U.S. execution facilities" being enough of a "locus of activity" for a transaction to be considered within the US. We note that the focus on the execution of a transaction, e.g., the "plumbing" by which transactions are finalized and settled, is a new concept for many of the Agencies. We do not believe that two non-US counterparties trading a security listed on the New York Stock Exchange have previously been considered to be trading within the US. Similarly, we do not believe that the transfer of a debt security between non-US counterparties would hitherto be considered a transfer within the US, notwithstanding that it requires a change of registered owner names at the Depository Trust Company. Further, we wonder whether the use by Covered Foreign Banks of correspondent relationships or dollar clearing facilities to settle non-US trades denominated in US dollars will bring such transactions under the provisions of the Proposed Rules.
It is easy to see the effect that strenuous enforcement of this prong will have on the use of the US financial markets, and US clearing and payment systems. First, issuers will have to dual list in order to permit trading on non-US exchanges. Newly created swap execution facilities will relocate outside of the US. Clearing and settlement systems will have to set up new entities outside of the US. Payment systems running through the US will be forced to skip that step; dollar clearing facilities will be required to obtain dollars through central bank swap facilities in order to satisfy demand for dollars outside of the US. Other execution facilities used by market participants will be forced to judge whether they are "execution" facilities for purposes of the Proposed Rules; for example, swap data repositories are entities set up to collect swap transaction data subject to mandatory reporting. If these entities are considered execution facilities they will need to be located outside of the US in order to permit Covered Foreign Banks to comply with the reporting requirements of Title VII of the DFA while remaining outside of the scope of section 619.
Perhaps the most direct problem with the "execution" prong is that it does not appear to be required at all by the language of section 619. That language notes, with regard to a transaction, the requirement that "the trading occurs solely outside" of the US (emphasis added). It does not look at all to the location of the execution of the trade to determine whether a trade has been done within or outside of the US. This prong appears to solely be the result of regulatory overreach by the Agencies. When weighed against the parade of horribles that would accompany its inclusion in a final rule, it seems clear that it should be dropped entirely, as it does not appear to assist the Agencies in achieving the purposes of section 619.
The Preamble states that the Proposed Rules "do not evaluate solely whether the risk of the transaction … rests solely outside of the United States, as such an approach would appear to permit [Covered Foreign Banks] to structure transactions so as to be 'outside of the United States.'"16 However, the following page states that the four criteria defining "solely outside of the" US are intended to ensure, among other things, that no "risks are retained in" the US.17 From the Proposed Rules, it appears that the Agencies are of several minds concerning how to ensure compliance with the requirements of section 619. In the text of the Proposed Rules, no Covered Foreign Bank could have any relationship to the US on any trade. Yet, the Proposed Rules seem to ignore the reality of the global marketplace, in which it is not so easy to place a national label on any particular transaction, as well as established precedent on whether a financial transaction is within the US. The Proposed Rules seek only to strenuously enforce the prohibition of section 619, while not being willing with the same strength to safeguard the statutory exemptions to that prohibition. If adopted, the end result could be a significant retrenching of the participation of non-US players in the US financial system. The Agencies should adopt a more balanced set of provisions that more accurately reflects the purpose and text of section 619.